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How Our T. Rowe Price Tax-Efficient Bucket Portfolios Have Performed

A three-year checkup on performance, tax efficiency, and holdings.

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One of the best ways to feel in control of your investments amid the market's inevitable ups and downs is to focus on what you can actually control. On the short list: your savings rate (or your withdrawal rate if you're retired), keeping your investment-related costs down, and managing for tax efficiency. That means taking advantage of any of the tax-advantaged savings receptacles on offer, like IRAs and company retirement plans. And if you hold assets outside of those tax-favored accounts, it's worthwhile to manage those accounts' tax efficiency, too.

Broad-equity market exchange-traded funds are great options for taxable accounts, but traditional equity index funds do a decent job of reducing the drag of taxes, too. Both feature ultralow turnover, and that common characteristic tends to be a more important determinant of tax efficiency than the investment wrapper. On the bond side, investors in higher tax brackets should favor municipal bonds and bond funds, whose income is typically free of federal and in some cases state and local taxes, too.

T. Rowe Price has long been one of Morningstar's favorite investment shops, a rare publicly traded firm that manages to balance the interests of corporate stakeholders alongside fundholders' interests. In many respects its lineup is well suited to building a retirement portfolio: The firm tends to prize disciplined strategies, retain managers for the long haul, and shy away from outsize risks. Those are worthwhile qualities for investors at any age, but especially for retirees.

But the process of building tax-efficient T. Rowe portfolios highlights a few shortcomings in the firm's lineup. T. Rowe's municipal-bond funds are topnotch, but it has fewer standout options to suit tax-conscious equity investors. The firm does field a lineup of basic equity-index offerings, but their costs are higher than many rivals' index funds and exchange-traded funds. Meanwhile, the firm's tax-efficient equity fund has a strong growth bias, including a heavy dose of mid-growth stocks; the associated volatility and its lack of dividend-paying stocks makes it less than ideal as a core equity holding for retirees.

As I did with my core T. Rowe Price Bucket portfolios, which are geared toward tax-sheltered holdings, I'll use the three-year anniversary of the portfolios to check up on their performance and assess whether any changes are in order.

Bucket Basics
Before getting into the checkup, it's worthwhile to review the basic strategy behind the portfolios.

As with all of the model portfolios, I used Morningstar's Lifetime Allocation Indexes to guide the asset-class exposures for these tax-efficient T. Rowe portfolios. That said, retirees should use their own cash-flow needs to "right-size" their allocations to each of the buckets. Say, for example, a retiree expects to spend 3% of her portfolio per year. Her Bucket 1 (cash) would hold 6% of her portfolio (two years' worth of living expenses), her Bucket 2 might hold another 24% of her portfolio (3% of her portfolio times eight years), and the remainder of her assets would go into Bucket 3.

To help populate the portfolios with specific funds, I leaned on Morningstar's medalist ratings. Because there weren't tax-efficient T. Rowe medalists in every category I wanted for these portfolios, I also consulted with Morningstar's manager research team: Katie Reichart, Sarah Bush, and Dan Sotiroff.

It's also important to note that the retirement portfolios aren't geared toward generating all of a retiree's cash-flow needs through current income. Rather, I've assumed that income distributions might help meet a portion of a retiree's income needs, but that he or she will also periodically rebalance, selling highly appreciated portions of the portfolio, to meet additional income needs.

Here's where the buckets come in. To help ensure a steady cash flow from the portfolio, the Bucket strategy bolts on a cash "bucket" alongside the long-term portfolio holdings. The retiree can spend out of the cash bucket, then periodically replenish that bucket with income distributions and rebalancing proceeds. The value of the cash bucket is primarily psychological: Knowing that one to two years' worth of living expenses are parked in cash, the retiree can put up with the volatility that will naturally accompany the long-term portfolio.

Aggressive Tax-Efficient Bucket Portfolio
Anticipated time horizon: 25 or more years 

Bucket 1: Years 1-2
8%: Cash (money market funds, online savings accounts, etc; I used T. Rowe Price Summit Municipal Money Market to calculate the portfolio's return)

Bucket 2: Years 3-10
10%:  T. Rowe Price Tax-Free Short-Intermediate (PRFSX)
22%:  T. Rowe Price Summit Municipal Intermediate (PRSMX)

Bucket 3: Years 11 and Beyond
45%:  T. Rowe Price Total Equity Market Index (POMIX)
15%:  T. Rowe Price International Equity Index (PIEQX)

Performance
3-Year Annualized Return: 7.72%
3-Year Tax Cost Ratio (Portfolio): 0.50%

The Aggressive T. Rowe Price Bucket Portfolio returned nearly 8% on an annualized basis over the past three years, a robust return that owes in no small part to its 60% equity weighting. The portfolio has also benefited from keeping things simple on the equity side. While T. Rowe Price Total Equity Market Index isn't the cheapest total market tracker in town, its 13% annualized return over the past three years trumps most active equity funds. Thanks to that fund's strong showing, in fact, the tax-efficient T. Rowe Price Bucket Portfolios have outperformed the core T. Rowe Price portfolios that are managed without regard for tax efficiency.

The portfolios have also done a decent job of reducing the drag of taxes. While T. Rowe's equity index funds aren't quite as tax-efficient at total equity ETFs, based on their three-year tax-cost ratios, their tax-cost ratios are respectable. Meanwhile the muni funds have done a great job of delivering income free of federal taxes. Thanks to their good tax efficiency, the total portfolio's tax-cost ratio weighs in at a respectable 0.50%.

Changes
None.

Moderate Bucket Portfolio
Anticipated time horizon: 20 or more years

Bucket 1: Years 1-2
10%: Cash

Bucket 2: Years 3-10
15%: T. Rowe Price Tax-Free Short-Intermediate
25%: T. Rowe Price Summit Municipal Income

Bucket 3: Years 11 and Beyond
40%: T. Rowe Price Total Equity Market Index
10%: T. Rowe Price International Equity Index

Performance
3-Year Annualized Return: 6.83%
3-Year Tax-Cost Ratio: 0.41%

The Moderate T. Rowe Price Bucket Portfolio returned nearly 7% on an annualized basis over the past three years. With a 50% equity weighting, it benefited from many of the same forces that lifted the Aggressive portfolio--namely, unadulterated exposure to the strong-performing U.S. equity market. As noted above, T. Rowe also fields a standout municipal-bond lineup. However, the funds tend to perform best--in relative terms--in muni-market downdrafts. Thus, their unremarkable recent gains in the "risk-on" bond market that has prevailed for most of the past three years is about what we'd expect to see.

Changes: None.

Conservative Bucket Portfolio
Anticipated time horizon: 15 Years

Bucket 1: Years 1-2
12%: Cash 

Bucket 2: Years 3-10
20%: T. Rowe Price Tax-Free Short-Intermediate 
28%: T. Rowe Price Summit Municipal Income 

Bucket 3: Years 11 and Beyond
30%: T. Rowe Price Total Equity Market Index 
10%: T. Rowe Price International Equity Index

Performance
3-Year Annualized Return: 5.54%
3-Year Tax-Cost Ratio: 0.33%

With roughly 60% of its assets in cash and bonds, this portfolio's returns were naturally below its more equity-heavy counterparts amid the strong equity market over the past three years. But like its Aggressive and Moderate counterparts, it managed to outperform the T. Rowe Price Conservative Bucket Portfolio, which is managed without regard for tax efficiency. This portfolio's tax efficiency was also excellent, thanks to its heavy tilt toward the tax-efficient muni funds.

Changes: None.

Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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